Riding the yield curve - why upward sloping?

CFA Level III
#1

Guys, could someone pls tell me the following:

So, with riding the yield: as the bond matures, its yield drops (less and less coupons left), and its price increases. Upon maturity, the prices drops, such that bonds converge to par. So, you sell the bond before it decreases in price.
Why does the curve must be upward sloping in order for the riding the yield curve strategy to function?
Thx!
C.

#2

You should try it with a downward sloping yield curve and see what happens.

Try a 5-year, annual-pay, 6% coupon bond. The 4-year par yield is 6% and the 5-year par yield is 5%. Figure out your 1-year HPR.

#3

Assuming Bonds with 2% coupon pay annually.

  • Bond A : Yield at 2% ,Price = 100, Maturity = 2 Yrs

  • Bond B : Yield at 2.5% ,Price = 98.12, Maturity = 4 Yrs

  • Bond C : Yield at 3% ,Price = 94.58, Maturity = 6 Yrs

  • Bond D : Yield at 3.5% ,Price = 89.69, Maturity = 8 Yrs

(Assuming under a stable yield curve)

The longer the maturity the higher the yield. And your investment time horizon is 2 years. You will buy Bond D at $89.69 and sell it at $94.58 in two years when its maturity becomes 6 yr bond as time passes. Your return will be more than just buying Bond A alone and hold over the same period. Because, if you purchase Bond A you will earn only 2% with no capital gain.

Therefore, this strategy is called ‘Riding the yield curve’.

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#4

Is Riding the yield curve strategy feasible with bonds priced at a discount only ?
What if a bond is priced at a premium (coupon is higher than YTM) ?
Price will seek to converge down to par and there will be a loss instead of profit. Is this correct ?

#5

Still works. As long as the yield curve is stable, the bond value increases when yield declines each year. And in Riding the Yield Curve, we do not hold the bond till maturity. You will hold for N years (< Maturity) then sell it off.

#6

I did some modeling in excel using this YC :
0.490%, 0.589%, 0.678%, 0.757%, 0.835%,

What I found out is:
if coupon = 0.5% => Roll Down Yield is positive for all bonds and holding periods (1-5 years),
if coupon =1.5% => RDY is negative for all bonds and holding periods.
if coupon > YTM of the bond invested => RDY mights still be positive for some holding periods.

#7

My guess is you took the change in bond price only and excluded the coupon.

RDY = (Change in Price + Coupon)/Beginning Price

#8

Your guess is right :wink: I have been messing up Rolling Yield with Rolldown Return. The results I showed are for the Rolldown Return.

The modelling for Rolling Yield is different - there is always at least one year of positive Rolling Yield whatever coupon is paid.

Tks, fino_abama

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#9

Thanks, Fino Abama :slight_smile:

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